Friday, November 04, 2005

Dividends and Share Buybacks

November 4, 2005 - /Bloomberg
Before the 1982-1998 bull market, dividends accounted for a very large portion of stock market returns. In fact, in the 1966-1982 bear market, they were the returns investors received while watching P/E compress under the market.
On a theoretical level, dividends are just a transfer from a company’s corporate account (an account partly owned by a shareholder but which he/she has no control over) to a shareholder’s brokerage account (an account which a shareholder has full control over.) Thus there is a transfer of “hypothetical” wealth to real wealth. Owning 0.0000005% of the $10 billion residing in the company's account is hypothetical wealth since it is NOT spendable; whereas $5000 in the shareholder’s brokerage account is real wealth as it is spendable wealth.
Since it was the shareholder's money to begin with, stocks usually drop by the amount of dividend paid, thus no value is created. That is exactly what happened to Microsoft (MSFT) when it paid its $30 billion dividend; though don’t forget the stock ran up substantially on the dividend announcement.
Interestingly, stocks have very little memory of the dividends which were paid out, thus the immediate decline is usually erased from investor memory in a NY minute.
This is where the theory and reality diverge: The majority of companies that don’t pay out a significant portion of cash flows in dividends (or stock buybacks, though I place more value on dividends, as stock buybacks could be postponed) more often than not end up destroying shareholder wealth in empire-building acquisitions or marginal capital investments (if they had better investments to begin with they would spend cash right away).
I’ve seen a study (I think it was presented by Cliff Asness at a CFA Institute conference, though I'm not 100% sure) which showed that there is very little correlation with dividend payout and a company’s growth rate. This goes against theory as theory doesn’t factor in destruction of capital by corporate management. A company that has a high dividend payout operates in a very different environment than the one that is swimming in shareholder cash, as rigid dividend payouts force management to maximize the value of every dollar retained.
Lloyds TSB (LYG) for example has a dividend payout of 80% - very few banks have that kind of payout. How is LYG different from other banks? It is not building a war chest to make an acquisition that will likely just raise the risk profile of the company and make management feel better about their ever-growing empire. LYG is looking for internal growth. It is focusing to better its relationship with its customers--a cheaper, higher-return-on-capital type of growth.
Cash that has not been paid out is often destroyed by management, thus making dividends a very important source of value creation. Microsoft’s large cash position did not create much shareholder value as it created incentive for MSFT to waste billions of dollars on “strategic” investments; a $5 billion investment in AT&T comes to mind. Or Mobil buying Montgomery Wards to “diversify its cash flows”--this qualifies as the dumbest waste of shareholder capital ever.
We are getting 8% dividend to wait for LYG stock to come back to “correct” (in our opinion) valuation. In the case of LYG, its super-sized dividend (as long as it is maintained) creates a floor under the stock, thus arguably reducing downside volatility in LYG shares. So I don’t see any problem with getting paid a dividend to wait.
My partner Michael Conn and I were discussing the issue of dividends and both came to one conclusion: A company that has a higher portion of total return coming from a dividend (everything else is constant) should trade at a higher multiple. Here is an example:
Company D (dividend) is growing earnings at 0% and pays a 10% dividend. Company G (growth) is growing earnings at 10% and pays no dividend, everything else is constant. Return from company G will be riskier relative to company D (read: lower P/E) as all of its return is expected to come from the market placing appropriate P/E (driven by a collection of external factors) on its growing earnings. Whereas all of company D’s return comes in the form of dividends--though its price is subject to the same whims as company G’s--its 10% dividend will produce a stable return in the interim. Thus company D is a less risky investment than company G.
Share buybacks are a trickier issue. I usually welcome share buybacks when a stock is undervalued. However, companies will often do anything to stimulate their EPS growth, even it means destroying shareholder wealth through share buybacks. For example, Colgate (CL) was buying back stock when it traded at 34 times earnings--that deed alone should have gotten its management and board fired.
Share buybacks when a stock is undervalued make sense as they help EPS growth and raise dividend yield at the same time. As the buyback lowers denominator, fewer shareholders own the same piece of pie. What is not to love?
Companies that have high return on capital and don’t have a very capital intensive business--our kind of companies--usually will have substantial free cash flows, which allows them to grow earnings organically, pay a dividend and buy back stock. I do not advocate leveraging the company to buy back stock for two reasons: First, higher return comes with higher risk, thus possibly putting downward pressure on a company’s P/E and offsetting any benefits from a share buyback. Second, leveraging a company’s balance sheet has finite limitations; the company can only take on so much debt. Whereas share buybacks from free (discretionary) cash flows are only limited by shares outstanding--a nice problem to have.
In addition, share buybacks (if done at appropriate valuation) and nice, fat dividends create shareholder value on another level as they reduce the risk the company has to take to produce a total return for shareholders. Share buybacks are not a substitute for organic growth, but are often an under-appreciated bonus.
Vitaliy N. Katsenelson, CFA Positions: LYG, MSFT This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.


Blogger Alex Khenkin said...

Vitaly, wouldn't you rather see the management apply a very strict value standard to any share buybacks? Something along the line of Ben Graham's 30% below book? As a small investor I'll take a dividend over share buybacks any day.
Small Investor Chronicles

11/08/2005 08:56:00 PM  

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